Theories Of Multiplier, Accelerator And Business Cycles

The Theory of Multiplier and Accelerator

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Concept of the Multiplier • With the increase in the level of Aggregate Level of Spending, there is an expansion of income & output in the economy • The income & output would increase by a multiple of aggregate spending. This multiple is known as multiplier • Earlier this concept was introduced by Kahn as Employment Multiplier • Later on Keynes had introduced the concept of Investment Multiplier 2

Types & Features • • • • • • •

Investment multiplier Government Expenditure multiplier Tax Multiplier Transfer Payments Multiplier Foreign Trade Multiplier Balanced Budget Multiplier Difference in Static & Dynamic Multipliers

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Static Multiplier • From the point of view of the static framework, if investment increases then by what multiple of investment does income rise? • Static multiplier means that any change in investment expenditure is assumed to have instantaneous impact on income and hence consumption. • In static equilibrium, Y=C+I+G • So ΔY/ ΔI=1/(1-c), where c=mpc • Thus, ΔY/ ΔI=1/s, where s=mps 4

Static Multiplier • In static equilibrium, Y=C+I+G • Or Y= C0 + C1Y + I + G, • ΔY= C1 Δ Y + Δ I • (1- C1) ΔY = Δ I • ΔY/ΔI= 1/(1- C1) • So ΔY/ΔI= 1/(1-C1), where C1=mpc • Thus, ΔY/ΔI=1/ S1, where S1=mps 5

Assumptions of Multiplier Theory • MPC remains constant • Time lag has been ignored in the model • Existence of excess capacity in the consumer goods industry • Therefore, prices are assumed to be constant. i.e. there is no rise in price owing to increase in demand 6

Leakages in Multiplier Process • • • • •

Paying off debts Holding of idle cash balances Imports Taxation Increase in Prices

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Numerical Problem on Multiplier • Suppose the level of investment is in an economy is Rs 200 crore and consumption function of the economy is: • C = 80 +0.75Y • What will be the equilibrium level of income? • What will be the increase in income if investment increases by Rs 25 crore? • Solution: Equilibrium income: • Y=C+I • Y = 80 +0.75Y + 200 • Y = 280 +0.75Y 8

Numerical Problem on Multiplier • • • •

(1- 0.75) Y = 280 or (1- 3/4) Y = 280 0.25Y = 280 or 1/4 Y = 280 Y = 280/0.25 = or 280*4= 1120 crores. If investment increases by then by how much income will increase will depend on the size of the multiplier • Multiplier = 1/(1-MPC) = 1/(1-0.75) = 4. • So for 25 crore increase in investment, income will go up 4 times to Rs. 100 crore 9

Paradox of Thrift • Multiplier = 1/s, mps=s Y

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Y2

Y1

National Income 10

THE BUSINESS CYCLE The Business cycle is the rise and fall of economic activity relative to the long-term growth trend of the economy

The peaking out 3 4 4 2

4 Recession

The boom 1

The upturn

The recession

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Concept of business/trade cycle • According to J.M.Keynes ‘A trade cycle is composed of periods of good trade characterised by rising prices & low unemployment percentages with periods of bad trade characterised by falling prices & high unemployment rate.’ • Business cycles are recurrent but irregular fluctuations in economic activity & occurs one after another • The time span of the period & phases may vary

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Phases of Business Cycles • Expansion (Boom, Upswing or Prosperity) • Peak (Upper Turning Point, when economic activity begins to slow down) • Contraction (Downswing, Recession or Depression) • Trough (Lower Turning Point, when economic activity begins to rise)

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Features of Business Cycles • Business cycles are irregular in nature • Fluctuations occur in a number of other variables simultaneously apart from production • Investment & Consumption of durable goods are more affected • Investment & Consumption of non durable goods are much less affected • Immediate effect on the level of inventory stock • Profits fluctuate more than any other incomes

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Investment Function and Accelerator • Till now we have seen the concept of the multiplier, which says that when investment increases by a certain amount, income/output increases by a multiple of that. • The acceleration principle defines exactly the opposite, and it says when income or consumption increase by a certain amount, investment rises by a multiple of that. This is known as induced investment. 15

Investment Function and Accelerator • The accelerator is the numerical value of the relation between the increase in investment arising out of increase in income. • As is understandable, to produce a given amount of output, it requires a certain amount of capital. If Y is the given income at t time period, then the amount of capital required to produce this output would depend on the capital-output ratio (COR), w. Mathematically, the relation is as given below: • Kt = w. Yt, so this COR w is equal to K/Y. 16

Investment Function and Accelerator The accelerator is assumed to be constant and greater than 1. Therefore, changes in output are made possible by changes in the amount (stock) of capital. Addition to capital stock over time is known as Investment. So when income increases from Yt to Yt+1 , capital stock will also increase from Kt to Kt+1. Or Kt – Kt-1 = w (Yt – Yt-1 ) = w ∆Yt Since Kt – Kt-1 = ∆ Kt = It, It = w ∆Yt, where Incremental capital/output ratio (ICOR)= ∆ Kt/∆Yt This relationship is known as accelerator principle. The capital/output ratio w is known as the accelerator.

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Features of the Accelerator • It = w ∆Yt, • The equation or the accelerator principle says that investment is a function of change in income. • If income and output remains same over time, i.e. Yt = Yt1, then investment will be zero. • Only if income and output increases over time, i.e. Yt > Yt-1 , then investment will be positive • If income and output decrease over time, i.e. Yt < Yt-1 , then investment will be negative or there will be disinvestment • This along with the multiplier explain business cycles, the booms, the downturn, recession and finally the upturn. 18

Working of the Business Cycle Increase in investment

Increase in Income through Multiplier

Increase in Induced Investment through Accelerator

Income and Aggregate demand change by an even larger amount 19

Working of the Business Cycle If income goes down in the next period

Decrease in Induced investment through Accelerator

Decrease in income through Multiplier

Consumption demand and Aggregate demand decrease by an even larger amount 20

Accelerator-Multiplier Interaction • Fluctuations in investment are the main cause of instability in free-enterprise economy. According to the accelerator principle, even if the growth of economy slows down, it can result in negative investment. Any change in components of aggregate demand will produce a multiplied effect, depending on the value of the multiplier (or MPC). This change in consumption, income will induce further change in investment and the extent of change would depend on the accelerator. 21

Numerical on Incremental Capital Output Ratio (ICOR)

Question: Given average real GDP growth rate of 9% and average investment ratio of 36%, estimate ICOR. Assuming that ICOR declines by 5% due to increase of productivity, how much investment is required if we plan for a growth of 10% per annum? Answer: ICOR = 36/9 =4. If ICOR declines by 5%, then 5%*4 = 0.2 New ICOR = 3.8 So required investment for a growth rate of 10% = 3.8 * 10 = 38%. 22

Causes of Business Cycles • There are many theories suggesting explanations for business cycles. • Climatic changes Under consumption Over Investment Keynes’ theory of effective demand, particularly investment

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Causes of Business Cycles • Booms/recessions can be generated by rise/fall in government expenditure, fiscal policy. • Similarly, a wave of optimism/pessimism can cause consumers to spend more/less than usual. • Similarly, firms may invest more (build up new capacities)/disinvest. • Another possible cause of recessions and booms is monetary policy. • A firm faced with high interest rates may decide to postpone building a new factory. • Households may be lured by cheap housing loans, and construction activities may boom. 24

Movements of Certain Macro economic variables during Business Cycles Variables can be classified as procyclical, countercyclical or acyclical, depending on the direction of change. • Procyclical- Variables have positive correlation. They usually increase during booms and decrease during recessions. Consumption, investment and employment are strongly procyclical. Construction, finance, retail also are procyclical. • Countercyclical- Variables have negative correlation. Unemployment is countercyclical. • Acyclical- Variables have zero correlation, implying no systematic relationship to the business cycle . capital stock is acyclical. 25

Cyclical behavior of macro economic variables according to time of occurrence Variables can be classified as leading, coincident or lagging variable. Leading Indicator: which occurs ahead of the occurrence of business circle variable. Coincident Indicator: which move up and down along with the business cycle variable. Lagging Indicator: which follow the business cycle variable after some time lag. 26

Leading Indicators – housing starts; – New orders for plant and equipment – stock prices; – demand for consumer durables; – consumer expectations; – New employment; – Deliveries by Companies; – Index of consumer confidence; – Index of business confidence; – Money growth rate (M2) 27

Coincident Indicators • • • •

Nonagricultural employment Index of industrial production Personal income Manufacturing and trade sales

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Lagging Indicators • • • • •

Wage rates Rate of inflation Consumer credits Lending rates Outstanding loans

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Cross Classification of Indicators Items Direction of Time of change occurrence Industrial output procyclical coincident Capacity utilization procyclical coincident Employment procyclical coincident Unemployment countercyclical coincident Inflation rate procyclical lagging Corporate profits procyclical coincident Short-term interest procyclical lagging Share price procyclical Leading Capital stock acyclical lagging 30